Posts Tagged ‘Liquidating Value’

Jae Jun at Old School Value has updated his great post back-testing the performance of net current asset value (NCAV) against “net net working capital” (NNWC) by refining the back-test (see NCAV NNWC Backtest Refined). His new back-test increases the rebalancing period to 6 months from 4 weeks, excludes companies with daily volume below 30,000 shares, and introduces the 66% margin of safety to the NCAV stocks (I wasn’t aware that this was missing from yesterday’s back-test, and would explain why the performance of the NCAV stocks was so poor).

Jae Jun’s original back-test compared the performance of NCAV and NNWC stocks over the last three years. He calculated NNWC by discounting the current asset value of stocks in line with Graham’s liquidation value discounts, but excludes the “Fixed and miscellaneous assets” included by Graham. Here’s Jae Jun’s NNWC formula:

NNWC = Cash + (0.75 x Accounts receivables) + (0.5 x  Inventory)

Here’s Graham’s suggested discounts (extracted from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

As I noted yesterday, excluding the “Fixed and miscellaneous assets” from the liquidating value calculation makes for an exceptionally austere valuation.

Jae Jun has refined his screening criteria as follows:

  • Volume is greater than 30k
  • NCAV margin of safety included
  • Slippage increased to 1%
  • Rebalance frequency changed to 6 months
  • Test period remains at 3 years

Here are Jae Jun’s back-test results with the new criteria:

For the period 2001 to 2004

For the period 2004 to 2007

For the period 2007 to 2010

It’s an impressive analysis by Jae Jun. Dividing the return into three periods is very helpful. While the returns overall are excellent, there were some serious smash-ups along the way, particularly the February 2007 to March 2009 period. As Klarman and Taleb have both discussed, it demonstrates that your starting date as an investor makes a big difference to your impression of the markets or whatever theory you use to invest. Compare, for example, the experiences of two different NCAV investors, one starting in February 2003 and the second starting in February 2007. The 2003 investor was up 500% in the first year, and had a good claim to possessing some investment genius. The 2007 investor was feeling very ill in March 2009, down around 75% and considering a career in truck driving. Both were following the same strategy, and so really had no basis for either conclusion. I doubt that thought consoles the trucker.

Jae Jun’s Old School Value NNWC NCAV Screen is available here (it’s free).


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Jae Jun at Old School Value has a great post, NCAV NNWC Screen Strategy Backtest, comparing the performance of net current asset value stocks (NCAV) and “net net working capital” (NNWC) stocks over the last three years. To arrive at NNWC, Jae Jun discounts the current asset value of stocks in line with Graham’s liquidation value discounts, but excludes the “Fixed and miscellaneous assets” included by Graham. Here’s Jae Jun’s NNWC formula:

NNWC = Cash + (0.75 x Accounts receivables) + (0.5 x  Inventory)

Here’s Graham’s suggested discounts (extracted from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

Excluding the “Fixed and miscellaneous assets” from the NNWC calculation provides an austere valuation indeed (it makes Graham look like a pie-eyed optimist, which is saying something). The good news is that Jae Jun’s NNWC methodology seems to have performed exceptionally well over the period analyzed.

Jae Jun’s back-test methodology was to create two concentrated portfolios, one of 15 stocks and the other of 10 stocks. He rolled the positions on a four-weekly basis, which may be difficult to do in practice (as Aswath Damodaran pointed out yesterday, many a slip twixt cup and the lip renders a promising back-tested strategy useless in the real world). Here’s the performance of the 15 stock portfolio:

“NNWC Incr.” is “NNWC Increasing,” which Jae Jun describes as follows:

NNWC is positive and the latest NNWC has increased compared to the previous quarter. In this screen, NNWC doesn’t have to be less than current market price. Since the requirement is that NNWC is greater than 0, most large caps automatically fail to make the cut due to the large quantity of intangibles, goodwill and total debt.

Both the NNWC and NNWC Increasing portfolios delivered exceptional returns, up 228% and 183% respectively, while the S&P500 was off 26%. The performance of the NCAV portfolio was a surprise, eeking out just a 5% gain over the period, which is nothing to write home about, but still significantly better than the S&P500.

The 10 stock portfolio’s returns are simply astonishing:

Jae Jun writes:

An original $100 would have become

  • NCAV: $103
  • NNWC: $544
  • NNWC Incr: $503
  • S&P500: $74

That’s a gain of over 400% for NNWC stocks!

Amazing stuff. It would be interesting to see a full academic study on the performance of NNWC stocks, perhaps with holding periods in line with Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update for comparison. You can see Jae Jun’s Old School Value NNWC NCAV Screen here (it’s free). He’s also provided a list of the top 10 NNWC stocks and top 10 stocks with increasing NNWC in the NCAV NNWC Screen Strategy Backtest post.

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Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

  • I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
  • I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
  • I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
  • I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

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In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value stocks in Japan since the mid 1990s. Grice’s findings are compelling:

My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

In the same article, Grice identifies five Graham net net stocks in Japan with market capitalizations bigger than $1B:

He argues that such stocks may offer value beyond the net current asset value:

The following chart shows the debt to shareholders equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year’s number equals 100. It’s clear that these companies have been aggressively delivering in the last decade.

Despite the “Japan has weak shareholder rights” cover story, management seems to be doing the right thing:

But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.

This is really extraordinary. The currency is a risk that I can’t quantify, but it warrants further investigation.

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Since last week’s Japanese liquidation value: 1932 US redux post, I’ve been attempting to determine whether the historical performance of Japanese sub-liquidation value stocks matches the experience in the US, which has been outstanding since the strategy was first identified by Benjamin Graham in 1932. The risk to the Japanese net net experience is the perception (rightly or not) that the weakness of shareholder rights in Japan means that net current asset value stocks there are destined to continue to trade at a discount to net current asset value. As I mentioned yesterday, I’m a little chary of the “Japan has weak shareholder rights” narrative. I’d rather look at the data, but the data are a little wanting.

As we all know, the US net net experience has been very good. Research undertaken by Professor Henry Oppenheimer on Graham’s liquidation value strategy between 1970 and 1983, published in the paper Ben Graham’s Net Current Asset Values: A Performance Update, indicates that “[the] mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.” That’s an outstanding return.

In The performance of Japanese common stocks in relation to their net current asset values, a 1993 paper by Bildersee, Cheh and Zutshi, the authors undertook research similar to Oppenheimer’s in Japan over the period 1975 and 1988. Their findings, described in another paper, indicate that the Japanese net net investor’s experience has not been as outstanding as the US investor’s:

In the first study outside of the USA, Bildersee, Cheh and Zutshi (1993)’s paper focuses on the Japanese market from 1975 to 1988. In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).

As an astute reader noted last week “…the test period for [the Bildersee] study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered:”

Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.

So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.

To see how the strategy has performed more recently, I’ve taken the Japanese net net stocks identified in James Montier’s Graham’’s net-nets: outdated or outstanding? article from September 2008 and tracked their performance from the data of the article to today. Before I plow into the results, I’d like to discuss my methodology and the various problems with it:

  1. It was not possible to track all of the stocks identified by Montier. Where I couldn’t find a closing price for a stock, I’ve excluded it from the results and marked the stock as “N/A”. I’ve had to exclude 18 of 84 stocks, which is a meaningful proportion. It’s possible that these stocks were either taken over or went bust, and so would have had an effect on the results not reflected in my results.
  2. The opening prices were not always available. In some instances I had to use the price on another date close to the opening date (i.e +/1 month).

Without further ado, here are the results of Montier’s Graham’’s net-nets: outdated or outstanding? picks:

The 68 stocks tracked gained on average 0.5% between September 2008 and February 2010, which is a disappointing outcome. The results relative to the  Japanese index are a little better. By way of comparison, the Nikkei 225 (roughly equivalent to the DJIA) fell from 12,834 to close yesterday at 10,057, a drop of 21.6%. Encouragingly, the net nets outperformed the N225 by a little over 21%.

The paucity of the data is a real problem for this study. I’ll update this post as I find more complete data or a more recent study.

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Highway Holdings Limited (NASDAQ:HIHO) is presently the only stock listed on the American Association of Individual Investors website with a Piotroski F_SCORE of 9, the highest possible Piotroski F_SCORE. An F_SCORE of 9 indicates that HIHO is “financially strong” in Piotroski’s framework. An F_SCORE of 8 indicates that it has failed on one dimension, and so on. Piotroski’s F_SCORE probably works better in the aggregate than in the case of a single company simply because the binary signal of each component is insufficiently granular to provide much information. Ideally, I’d identify 30 high BM companies scoring 9 on the Piotroski F_SCORE and construct a portfolio from them. The only problem with the practical implementation of that strategy is there aren’t 30 high BM companies scoring 9 on the Piotroski F_SCORE, so we’re stuck with HIHO as the only representative of Piotroski’s F_SCORE in practice. For that reason, this test is imperfect, but that does not mean it is not useful. It analyses more dimensions that I typically do, so perhaps it will work fine for a single company.

HIHO closed Friday at $1.73, giving it a market capitalization of $6.5M. Book value is $11.4M, or $3.03 per share, which means that HIHO is trading at approximately 57% of book value (a P/B of 0.57 or a BM of 1.75). I estimate the liquidation value to be around $5.2M or $1.39 per share, which means that HIHO is trading at a premium to its liquidation value and is not, therefore, a liquidation play. I regard the $1.39 per share liquidation value as the downside in this instance, and the $3.03 per share book value as the upside.

About HIHO

HIHO is a foreign issuer based in Hong Kong. From the most recent 6K dated November 10, 2009:

Highway Holdings produces a wide variety of high-quality products for blue chip original equipment manufacturers — from simple parts and components to sub-assemblies. It also manufactures finished products, such as LED lights, radio chimes and other electronic products. Highway Holdings operates three manufacturing facilities in the People’s Republic of China.

The value proposition: Piotroski’s F_SCORE

The objective of Piotroski’s F_SCORE is to identify “financially strong high BM firms.” It does so by summing the following 9 binary signals (for a more full explanation, see my post on Piotroski’s F_SCORE):

F_SCORE = F_ROA + F_[Delta]ROA + F_CFO + F_ ACCRUAL + F_[Delta]MARGIN + F_[Delta]TURN + F_[Delta]LEVER + F_[Delta]LIQUID + EQ_OFFER.

The components are categorized as follows:

  • F_ROA, F_[Delta]ROA, F_CFO, and F_ACCRUAL measure profitability
  • F_[Delta]MARGIN and F_[Delta]TURN measure operating efficiency
  • F_[Delta]LEVER, F_[Delta]LIQUID, and EQ_OFFER measure leverage, liquidity, and source of funds

The following are based on HIHO’s March 31 year end accounts set out in its 20F dated June 22, 2009. Here’s how HIHO achieves its F_SCORE of 9:

  1. F_ROA:  Net income before extraordinary items scaled by beginning of the year total assets (1 if positive, 0 otherwise). HIHO’s net income for 2009 was $0.8M/$17.8M = 0.04, which is positive so F_ROA is 1.
  2. F_CFO: Cash flow from operations scaled by beginning of the year total assets (1 if positive, 0 otherwise). HIHO’s cash flow from operations for 2009 was $2.0M/$17.8M = 0.11, which is positive so F_CFO is 1.
  3. F_[Delta]ROA: Current year’s ROA less the prior year’s ROA (1 if positive, 0 otherwise). HIHO’s ROA for 2009 was 0.04, and its ROA for 2008 was -0.09, and 0.04 less -0.09 = 0.13, which is positive so F_ROA is 1.
  4. F_ACCRUAL: Current year’s net income before extraordinary items less cash flow from operations, scaled by beginning of the year total assets (1 if CFO is greater than ROA, 0 otherwise). HIHO’s net income for 2009 was $0.8M/$17.8M less cash flow from operations of $2.0M/$17.8M. CFO > ROA so F_ACCRUAL is 1.
  5. F_[Delta]LEVER: The change in the ratio of total long-term debt to average total assets year-on-year (1 if decrease, 0 if otherwise). HIHO’s long-term debt ratio in 2009 was $0.6M/average($17.8M and $20.5M) = 0.03 and in 2008 was $0.8M/average($22.4M and $20.5M) = 0.04, which is a decrease year-on-year so F_[Delta]LEVER is 1.
  6. F_[Delta]LIQUID: The change in the current ratio between the current and prior year (1 if increase, 0 if otherwise). HIHO’s current ratio in 2009 was $14.9M/$5.9M = 2.53 and in 2008 was $16.8M/$9.2M = 1.83, which means it was increasing year-on-year and so F_[Delta]LIQUID is 1.
  7. EQ_OFFER: 1 if the firm did not issue common equity in the year preceding portfolio formation, 0 otherwise.  HIHO reduced its common equity on issue in 2009 by 99,000 shares, so EQ_OFFER is 1.
  8. F_[Delta]MARGIN: The current gross margin ratio (gross margin scaled by total sales) less the prior year’s gross margin ratio (1 if positive, 0 otherwise). HIHO’s gross margin ratio in 2009 was $6.7M/$33.7M = 0.2 and in 2008 was $5.1M/$33.2M = 0.15. 0.2 less 0.15 = 0.05, which is positive, so F_[Delta]MARGIN is 1.
  9. F_[Delta]TURN: The current year asset turnover ratio (total sales scaled by beginning of the year total assets) less the prior year’s asset turnover ratio (1 if positive, 0 otherwise). HIHO’s 2009 year asset turnover ratio was $33.7M/$17.8M = 1.9  and in 2008 was $33.2M/$20.5M = 1.6. 1.9 less 1.6 = 0.3, which is positive, so F_[Delta]TURN is 1.

HIHO has a perfect 9 on the Piotroski F_SCORE.

The value proposition: Liquidation value

Here is the liquidation value analysis based on its most recent quarterly financial statement to September 30, 2009 (the “Book Value” column shows the assets as they are carried in the financial statements, and the “Liquidating Value” column shows our estimate of the value of the assets in a liquidation):


With a book value of $11.4M against a market capitalization of $6.5M, HIHO has a book-to-market ratio of 1.75 and is therefore a high BM stock. This makes HIHO an ideal candidate for the application of the Piotroski F_SCORE, which seeks to use “context-specific financial performance measures to differentiate strong and weak firms” within the universe of high BM stocks. HIHO scores a perfect 9 on the Piotroski F_SCORE, which indicates that it is a “strong firm” within that framework. As a check on the downside, I estimate the liquidation value to be around $5.2M or $1.39 per share. For these reasons, HIHO looks like a reasonable bet to me, so I’m adding it to the Special Situations portfolio.

HIHO closed Friday at $1.73.

The S&P500 Index closed Friday at 1,105.98.

[Full Disclosure: I do not have a holding in HIHO. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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The phenomenal Zero Hedge has an article, Goldman Claims Momentum And Value Quant Strategies Now Overcrowded, Future Returns Negligible, discussing Goldman Sachs head of quantitative resources Robert Litterman’s view that  “strategies such as those which focus on price rises in cheaply-valued stocks…[have] become very crowded” since August 2007 and therefore unprofitable. The strategy to which Litterman refers is “HML” or “High Book-to-Price Minus Low Book-to-Price,” which is particularly interesting given our recent consideration of the merits of price-to-book value as an investment strategy and the various methods discussed in the academic literature for improving returns from a low P/B strategy. Litterman argues that only special situations and event-driven strategies that focus on mergers or restructuring provide opportunities for profit:

What we’re going to have to do to be successful is to be more dynamic and more opportunistic and focus especially on more proprietary forecasting signals … and exploit shorter-term opportunistic and event-driven types of phenomenon.

In a follow-up article, More On The Futility Of Groupthink Quant Strategies, And Why Momos Are Guaranteed To Lose Money Over Time, Zero Hedge provides a link to a Goldman Sachs Asset Management presentation, Maybe it really is different this time (.pdf via Zero Hedge), from the June 2009 Nomura Quantitative Investment Strategies Conference. The presentation supports Litterman’s view on the underperformance of HML since August 2007. Here’s the US:

Here’s a slide showing the ‘overcrowding” to which Litterman refers:

And its effect on the relative performance of large capitalization value to the full universe:

The returns get really ugly when transaction costs are factored into the equation:

A factor decay graph showing the decline in legacy portfolios relative to current portfolios, lower means and faster decay indicating crowding:

Goldman says that there are two possible responses to the underperformance, and characterizes each as either a “sticker” or an “adapter.” The distinction, according to Zero Hedge, is as follows:

The Stickers believe this is part of the normal volatility of such strategies

• Long-term perspective: results for HML (High Book-to-Price Minus Low Book-to-Price) and WML (Winners Minus Losers) not outside historical experience

• Investors who stick to their process will end up amply rewarded

The Adapters believe that quant crowding has fundamentally changed the nature of these factors

• Likely to be more volatile and offer lower returns going forward

• Need to adapt your process if you want to add value consistently in the future

In Contrarian Investment, Extrapolation, and Risk, Josef Lakonishok, Andrei Shleifer, and Robert Vishny argued that value strategies produce superior returns because most investors don’t fully appreciate the phenomenon of mean reversion, which leads them to extrapolate past performance too far into the future. Value strategies “exploit the suboptimal behavior of the typical investor” by behaving in a contrarian manner: selling stocks with high past growth as well as high expected future growth and buying stocks with low past growth and as well as low expected future growth. It makes sense that crowding would reduce the returns to a contrarian strategy. Lending further credence to Litterman and Goldman’s argument is the fact that the underperformance seems to be most pronounced in the large capitalization universe (see the “A closer look – value” slide) where the larger investors must fish. If you’re not forced by the size of your portfolio to invest in that universe it certainly makes sense to invest where contrarian returns are still available. Special situations like liquidations and event-driven investments like activist campaigns offer a place to hide if (and when) the market resumes the long bear.

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